Remembering When the Single-Member LLC Is and When It Isn’t
Beat U. Steiner
For what purposes does the single-member LLC exist and for what purposes doesn’t it exist? Confusion on this point can be costly.
AS I RECALL, the first case I studied in my corporations class at law school was a piercingthe-corporate-veil case involving a taxi cab business in which each taxi was owned by a separate corporation. It struck me as a sensible, albeit shrewd, way to conduct business. At that time, achieving limited liability for a single busi-
ness owner pretty much required incorporation. But incorporation had a tax cost, as well as transaction costs. With the advent of the limited liability company, the check-the-box regulations, single-member limited liability companies (“SMLLCs”) and the concept of disregarded entities—“a tax nothing”—the tax cost to
Beat U. Steiner is a partner in Steiner, Darling & Hutchinson LLP, Denver, Colorado. He is former chair of the Colorado Bar’s Real Estate Section and a co-chair of the ABA Real Property and Probate Section’s Joint Committee on Limited Liability Entities. This article is based on a paper the author prepared for an August 2001 seminar sponsored by ABA’s Section of Real Property Probate and Trust Law.
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The Practical Real Estate Lawyer
March 2002
limited liability disappeared. It would seem that, today, choosing an SMLLC as the vehicle for a sole proprietorship is a “no-brainer.” There are, however, many matters to be considered including, of course, the transaction costs. My guess is that the single most difficult part for a sole proprietor who chooses to do business as an SMLLC is remembering when he or she is, and when he or she isn’t, a limited liability company. Some people think of it as a “left brain/right brain” issue. I think of “The Invisible Man.” However you think of it or choose to describe it, you must teach your client when the business entity exists (generally for legal purposes) and when it doesn’t (generally for tax purposes). Confusion can be costly. HOLDING ONESELF OUT • There is a huge temptation, especially for a sole proprietor, to go to an attorney’s office or a bookstore, fill out the necessary paperwork to form an SMLLC and give no further thought to it since it is, after all, a disregarded entity. (I can hear it now, “But my lawyer told me….”) We all know that the piercing-the-veil risk is high for these business proprietors. What should the business proprietor do? • Execute an operating agreement—under some LLC statutes, the scope of limited liability protection is severely diminished unless matters, such as required capital contributions, are dealt with in a written agreement; • Give the SMLLC a reasonable amount of capital; • Keep all finances of the SMLLC separate from those of the member and other entities; • Use the name of the business as filed when the SMLLC was formed, including the limited liability company designation, on all papers used in the business—business cards, stationery, invoices, and the like;
• File any papers necessary to conduct business in a trade name, if the business is not conducted in the filed (or “true”) name of the entity; • Open all accounts and execute all purchase orders, leases, contracts, and other written agreements in the name of the SMLLC; • Obtain all governmental licenses in the name of the SMLLC; • Determine whether to obtain an employer identification number (“EIN”)—the IRS requires it if the SMLLC has employees, but IRS pronouncements conflict on what is required if the SMLLC does not. The IRS will issue an EIN to a SMLLC without employees; • Open a separate bank account in the name of the SMLLC. This may be tricky if the proprietor is using his or her individual taxpayer identification (“social security”) number, since bank employees are trained to get an EIN for an entity. Avoiding difficulties at the bank may be reason enough to obtain an EIN for an SMLLC without employees; • Acquire, hold, convey, and otherwise deal with all property of the business, real and personal, in the name of the SMLLC; and • Obtain insurance that specifically covers the SMLLC. In short, “hold oneself out” as a limited liability company in all ways possible in the conduct of business. The few “piercing-the-veil” cases that have been decided suggest that the fact that an SMLLC is a disregarded entity for tax purposes (and the things that go along with that status—no separate tax returns, perhaps no separate taxpayer identification number) will, as a practical matter, persuade judges to pierce the veil more readily with an SMLLC than other limited liability entities. See Elizabeth S. Miller, “The Advent of LLCs and LLPs in the Case Law: A Survey of Cases Dealing with Registered Limited Liability Partnerships and Limited
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Liability Companies,” Partnerships and LLCs— Important Case Law Developments 2000 Program, American Bar Association Annual Meeting, New York, New York, July 11, 2000. “CONVERTING” TO AN SMLLC • Forming an SMLLC for an existing business presents a similar temptation—to go to an attorney’s office or a bookstore, fill out the necessary paperwork to form an SMLLC and continue conducting business as before. Once again, the “piercing-the-veil” risk is high for these proprietors unless they take the steps mentioned above. In addition, the consequences could be disastrous unless the proprietor understands that “converting” to an SMLLC is not a conversion at all—it is more akin to a sale or contribution transaction. All the considerations, other than the tax considerations, applicable when assets are sold or are contributed to an entity apply to the formation of an SMLLC to continue the business or investment purposes of the business. In addition to the considerations noted in forming a new SMLLC, the legal consequences of conveying, or endeavoring to convey, each asset and liability of the business to the SMLLC must be considered. Conveying Real Property to the SMLLC Real property poses the most difficult challenges. A deed, conveying the property from its existing owner to the SMLLC, must be executed and recorded. Such a conveyance will raise a variety of issues: • Will any transfer taxes, deed stamps, gains taxes, or similar impositions become payable? • Will the real property be re-assessed for real estate tax purposes as the result of the conveyance? • Will the conveyance trigger a “due-on-sale clause” or any notice requirement in any mortgage encumbering the property?
• Will any rights personal to the present owner be lost as a result of the conveyance (e.g., licenses, personal covenants)? Title Insurance The SMLLC probably will not be protected by a title insurance policy in favor of the existing owner. The American Land Title Association form of owner’s title insurance policy (Form B Rev. 10-17-92), for example, defines the “insured” as: “the insured named in Schedule A and…those who succeed to the interest of the named insured by operation of law as distinguished from purchase, including, but not limited to, heirs, distributees, devisees, survivors, personal representatives, next of kin, or corporate or fiduciary successors.” An SMLLC to which real property has been transferred does not fit within this definition of the “insured,” and title insurance coverage will not be extended to it under the sole proprietor’s policy. If the transfer from the sole proprietor is made by a general warranty deed, the sole proprietor may have coverage under its title insurance for claims against the sole proprietor for breach of its warranty. Under a general warranty deed, however, the liability of the sole proprietor is not limited to the amount of the title insurance. And worse, in some jurisdictions, damages in a breach of title warranty claim is limited to the amount of consideration the grantors received, which, in a transfer from a sole proprietor to an SMLLC, is probably nothing. So the title insurance company has no liability under its policy. Thus, the sole proprietor should consider obtaining a new title insurance policy insuring the SMLLC, expensive as it may be. The cost of such a policy can be reduced if a “reissue” rate applies or if the owner’s policy is obtained at the same time as a loan policy is obtained in connection with the financing or a re-